Life Insurance Trusts
A trust is created when a trustor, or property owner, gives property or assets to another party.
The party receiving this property is known as the trustee.
In turn, the trustee manages the assets owned by the trust for the financial benefit of a beneficiary.
The beneficiary of a trust is usually a relative or business partner of the trustor.
This insider's guide provides an overview of the most common types of life trusts and the advantages they offer. We've also explained the best type of permanent life insurance for funding a trust, guaranteed universal life insurance.
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With a life insurance trust, the property that the trustor will transfer to the trustee is in the form of a life insurance policy. When the trustor passes away, their life insurance policy will pay a monetary death benefit to the trust. The trustee will then transfer the money from the trust to beneficiary as the trustor directed before passing away.
What Are Life Insurance Trusts Used For?A life insurance trust is not necessary if you are purchasing life insurance as income replacement for your spouse.
A trust is usually created to separate the monetary value of your life insurance policy’s death benefit from the value of your estate or to allow you to retain some control of your assets after you pass away.
A life insurance trust can be created for a number of reasons. In this article we will cover the most common reasons that people create a life insurance trust. These reasons include:
• Buy-Sell Agreements - A buy-sell agreement is a type of trust that is created to payout a business owner’s share of their business to their surviving family when they pass away.
• Charitable Remainder Trust - These types of trusts usually work in conjunction with a wealth replacement trust. Please see the “Wealth Replacement Trusts" section below.
• Dynasty Trust - A dynasty trust is another name for an exemption trust. They are created to avoid or reduce estate tax obligations. Please see the “Irrevocable Life Insurance Trust” section below.
• Educational Trust - An educational life insurance trust is a trust funded by life an insurance policy to pay for a college education for children or grandchildren.
• Estate Equalization Trust - This type of trust is designed to leave equal assets behind for each of your beneficiaries.
• Exemption Trust - An exemption trust is another name for an Irrevocable Life Insurance Trust or ILIT. These trusts are used in estate planning to reduce or avoid estate tax obligations.
• Irrevocable Life Insurance Trust - An Irrevocable Life Insurance Trust, or “ILIT,” is used to fund an exemption trust or a dynasty trust.
• Special Needs Trust - These trusts are used to provide children with special needs a source of monetary benefits without jeopardizing their eligibility for Social Security and Medicaid benefits or any other state assistance programs.
• Supplemental Needs Trust - A supplemental needs trust is also known as a special needs trust. Please see the “Special Needs Trust with Life Insurance” section below.
• Wealth Replacement Trust - A wealth replacement trust is a trust designed to reduce your estate tax obligations and preserve the inheritance of your surviving family.
Buy-Sell Agreements for Business Owners
Buy-sell agreements, also known as buyout agreements, are a form of a life insurance trust that is created to protect each business owner’s share of the business.
Buy-sell agreements are also designed to protect the business itself.If a business owner passes away, a business is usually forced to file bankruptcy or sell off assets to pay out the deceased owner’s share of the business. This money is typically paid to their spouse of their surviving family.
To mitigate this risk and prevent your spouse and business partners from having to work together, businesses will set-up a buy-sell agreement funded with life insurance. There are two types of buy-sell agreements for businesses; Stock Redemption and Cross Purchase.
With a cross-purchase buy sell-agreement, two business partners buy a life insurance policy on each other. The death benefit of this policy should be for approximately half of the value of the business. A life insurance company will consider the book value, market value, or capitalization of earnings to determine how much coverage each owner can qualify for.
• Book Value
The book value of your business is the value of your businesses assets after the business’ liabilities have been subtracted.
• Market Value
The market value of a business is usually determined by a offer to buy your business.
• Capitalization of Earnings
The capitalization of earnings equation is a bit more complex, but it is ideal for service-based businesses without a lot of tangible assets. This formula relies on earnings from previous years, or forecasted earning for future years.
Stock Redemption Agreement
With a stock redemption agreement, the business buys a life insurance policy on each owner which is equal to the percentage of the company they own, and each owner is party to the agreement. Once the value of the business is established, the amount of each partner’s ownership share will need to be determined.
For Example: If you determine that your business is worth about $10,000,000 and you have three equal owners, we suggest that your business buys a life insurance policy for each owner with a death benefit of approximately $3,333,000.
On the other hand, if the division of ownership within your business is unequal, you will need to purchase policies that correspond with the percentage of the business each person owns. This means if one owner controls 40% of the company and the other two control 30% each, the owner with the largest share should purchase a $4,000,000 policy while the other two owners will need to each have $3,000,000 of coverage.
If an owner were to pass away, this money is then paid to the surviving members to the family to pay out their ownership share of the business. This prevents spouses from becoming a business partner, and it prevents businesses from selling assets to pay the surviving spouse. Additionally, your business should purchase term life insurance if you plan to sell your business within 10, 15, or 20 years.
Make sure your term extends past the amount of years that you anticipate to sell your business. If you intend to run your business for the rest of your life, each business owner should purchase a permanent life insurance policy.
A permanent policy is designed to provide coverage for your entire life whereas most term life insurance policies expire by the age of 80. If you think you will still have a controlling interest in your business after 80 and you have no plans to sell the business before then, your business should purchase permanent life insurance for your buy-sell agreement.
The best type of policy for this is a guaranteed universal life insurance policy. These policies work just like term life insurance, but you can pick the exact age you want your coverage to last. Some of these permanent life insurance policies offer affordable coverage with a guaranteed rate and death benefit that will extend past the age of 100.
Educational Life Insurance Trust
An educational life insurance trust will allow you to determine the terms of your trust, or how the money you leave behind from your heirs is spent. This ensures that they money you leave behind to fund an education is used as intended.
These particular trusts are funded by a permanent life insurance policy. When you pass away, your life insurance policy will pay the death benefit from your life insurance to your trust instead of paying the cash benefit directly to your loved ones.
This is important because once this death benefit from your policy is paid out, you are no longer in the picture and no one will be able to control how the money you have left behind is spent.
Client’s often call us and ask, “How can I make sure my children spend the money I leave them on their education when they turn 18? I don’t want them blowing all the money I leave behind.”If you name a minor as the beneficiary on your life insurance policy, in most states, as soon as you child reaches the age of 18, they will have full control of the money that is left behind.
An 18 year old child who is grieving and has a pocketful of cash is a scary concept for many parents and grandparents. If your life insurance policy has named a trust as the beneficiary of your policy instead of an individual, the death benefit from your life insurance policy will pay directly to your trust when you pass away.
This avoids court intervention and will allow the trust to allocate money to your children or grandchildren exactly as you see fit. When you set up our trust, you must name a trustee who is usually a family member or an attorney.
The trustee can be directed to use the money from your trust to pay for educational cost only, or whatever terms you see fit. When naming a trustee, make sure you select someone who is trustworthy and responsible with money.
When purchasing a policy to pay for a college education, you need to buy a policy that you will not outlive. If you purchase a short term policy, and you outlive the coverage, the money you have paid into the policy is lost and your children or grandchildren will not have the money that you intended to leave them for their education.
If you are confused or looking for direction, we can help you with an affordable policy that will extend your life insurance coverage until the age of 90 or later. This type of coverage is called guaranteed universal life insurance and it offers level rates and fixed coverage without requiring an investment.
Estate Equalization Trust with Life Insurance
An estate equalization trust is designed to leave an equal inheritance behind for each of your beneficiaries. After you pass away, especially if you have a large estate, your beneficiaries will be forced to attempt to divide your assets amongst themselves, or sell off all of your assets for a fraction of their value.
To equalize the amount of assets that you leave behind for each child, permanent life insurance can be purchases to settle out any differences.
This prevents your beneficiaries from being forced to sell your assets that have and prevent them from fighting over what is left behind.
For Example: You and your wife own a house in the suburbs of Seattle that was recently appraised for $500,000. You have two children, a son and a daughter. Your daughter married her high school sweetheart and dreams of raising her children in the same house she grew up in.
Your son moved to California to pursue snowboarding and would love some startup money to start his own snowboarding school in Lake Tahoe. Since your daughter is set on inheriting your house that is completely paid off, you can purchase a permanent life insurance policy for $500,000 to leave to your son.
When you pass away, you can leave your home to your daughter and leave the death benefit from your life insurance policy to your son. This prevents disputes between your family members when you are gone because you will be leaving each one of your children with an equal inheritance.
Estate equalization trusts also work for multiple beneficiaries or multiple assets of varying value. If your estate is worth more than $5,000,000, an estate equalization trust can also separate your life insurance policy’s death benefit from your estate, preventing your heirs from facing estate taxes. To learn more about this, please read the section, “Irrevocable Life Insurance Trust for Estate Planning.”
Irrevocable Life Insurance Trust for Estate Planning
Estate planning is one of the most common reasons that people set up a life insurance trust. Estate planning involves buying life insurance to reduce or avoid estate and inheritance taxes. To avoid or reduce your estate tax obligation for future generations, financial planners, bankers, and estate attorneys recommend creating an Irrevocable Life Insurance Trust, also known as an ILIT.
For estate tax purposes, an irrevocable life insurance trust will separate your life insurance policy’s death benefit from your estate.
These trusts are also commonly referred to as dynasty trusts or exemption trusts.Since the IRS views life insurance as an asset, if your total assets exceed the current year’s estate tax exemption, they are subject to estate taxes. An irrevocable life insurance trust separates the death benefit of your life insurance policy from the value of your estate.
As of 2023, the estate tax exemption was set at $12,920,000 for individuals, but this amount will decrease to roughly $6 million in 2026. If your estate and the death benefit from your life insurance policy is worth more than the current exemption, the value of your estate that exceeds this amount will be subject to a 40% tax rate.
This means that your life insurance policy could actually increase your estate’s tax liability for your intended beneficiary or beneficiaries. The IRS will collect all taxes due on your estate within nine months of your passing. We often hear stories from family members that have had to sell prized family possessions or conduct estate sales to raise the money needed to settle with the IRS.
This can be extremely stressful when someone is already grieving the loss of a family member. It is very common for these situations to end with “fire-sales.” This means the family is rushing to sell assets for much less than they are worth in order to pay for the estate taxes. It’s also important to note that the estate tax exemption can change at any time with changes to legislation.
To avoid this dilemma, you will want to set up an irrevocable life insurance trust to own your life insurance policy. By listing the trust as the owner of your policy, the death benefit becomes separate from your estate. This tax free money is then used to pay off any outstanding estate taxes due to the IRS, allowing your estate to be passed onto future generations without estate tax obligations. An irrevocable life insurance trust needs to be funded by a permanent policy to function correctly.
Do not buy a term policy that you will outlive. We recommend purchasing a policy that will guarantee your rates to age 90, 95, 100, 105, 110 depending on the longevity in your family.
These policies are also known as term-to-90, term-to-95, term-to-100, etc. They DO NOT build a cash value and the rates are fixed and guaranteed just like term insurance. This allows life insurance to remain affordable because you do not have to invest extra money into your policy and you pay for the cost of the life insurance only.
Special Needs Trust with Permanent Life Insurance
A special needs trust is a trust designed to provide money to a disabled beneficiary without sacrificing their eligibility for government benefits like Social Security or Medicaid. The laws about receiving assistance from SSI and SSDI are very strict, and if your child has access to more than $2,000 in assets, they may be ineligible from receiving these benefits and other government benefits.
To prevent your child from being ineligible for Medicaid and Social Security government benefits, a special needs trust may need to be created. A special needs trust is usually funded by an inheritance or a parent’s life insurance policy.
The purpose of the trust is to separate the death benefit of your life insurance policy from your child’s personal assets. If a special needs trust controls the inheritance for your child, it is not considered to be a personal asset and it will not affect their eligibility for life insurance.
The life insurance payout is held by the special needs trust and managed by a trustee, whom you appoint. The trustee of your special needs trust will allocate the money to your child as needed. You can name a family member, bank executive, or attorney, as the trustee of your special needs trust.
A special needs trust is usually funded by a life insurance policy purchased by the parent or guardian of the child with special needs. In order for these trusts to work properly, your trust should be funded by a permanent life insurance policy that you will not outlive.
When you pass away, your life insurance policy will pay a death benefit to fund your trust.
If you outlive your life insurance policy, your policy will not pay a death benefit to your trust.
The two types of life insurance coverage that are the best fit and most popular for a special needs trust are guaranteed universal life insurance and second to die life insurance. A guaranteed universal life insurance policy provides lifetime insurance to one person and pays out when they pass way.
These policies are also known as term-to-90, term-to-95, term-to-100, etc., and they are commonly purchased on the family breadwinner to provide the child’s caregiver with an income, especially if they are a spouse. A Second-to-die insurance policy, also known as survivorship life insurance, covers two individuals, which is usually the parents of a special needs child, and pays out as a lump sum when both insured people pass away.
A second to die policy is less expensive because it is based off of the longevity of two people instead of one. The downside to these types of policies is that your spouse will be solely responsible for the cost of your child’s caregiving needs and the cost of the life insurance after you pass away. Women tend to live longer than men; so if your spouse’s income, pension, retirement, or Social Security does not pass onto you after their death, this may not be your best option.
When you, or you and your spouse pass away, the death benefit from your life insurance policy will be paid to your child’s special needs trust instead of paying to your child.
This will keep the insurance payout separated from your child’s personal assets so it does not affect their eligibility for government benefits.In addition, the special needs trust will allow you to maintain some control of your life insurance proceeds after you are gone. You must appoint a trustee to control the trust after you are gone. A trustee for a special needs trust is typically a family member, attorney, or bank executive. If you’re not sure which type of policy is better for your situation and needs, give us a call and we’ll be happy to explain your options.
Wealth Replacement Trust
A wealth replacement trust is a two-trust estate plan that allows you to reduce your tax obligations through charitable causes, while leaving an inheritance behind for your beneficiaries. A wealth replacement trust is created in conjunction with a charitable remainder trust to allow you to donate to the charity or charities that you chose, while leaving a tax-free inheritance behind to preserve future generations.
When correctly utilized, your trusts will essentially pay for a life insurance policy by avoiding the capital gains tax on your initial investment. Your life insurance policy will then provide the funds needed to allow you to leave behind a tax-free inheritance to whomever you chose.
To set up a wealth replacement trust, you will first need to set up a trust designed to preserve your income for the rest of your life. The best vehicle for this is a charitable remainder trust. A charitable remainder trust allows you to transfer your wealth without incurring federal taxes on your long term capital gain.
This will allow you to retain a strong base of capital that you will draw retirement income from. With a charitable remainder trust, you defer your charitable donation until after you pass away. For Example: Let’s say you own a considerable amount of stock worth about $1,500,000 and you're collecting a modest dividend of 2.5%.
You have owned the stock for years and your initial investment on the stock was roughly $175,000. You want to sell your stock to invest the capital into an investment vehicle that will earn a more lucrative rate of return, but you don’t want to face about $200,000 in capital gains taxes on your initial investment.
To avoid these capital gains taxes, you can donate your stock to the charitable remainder trust and instruct your trustee to sell the stock. Your trustee will then reinvest this money into a more lucrative investment of your choice.
You can then draw off this investment value and any interest that it may produce for the rest of your life. This allows your full investment value to grow more rapidly and you will not be faced with any capital gains taxes. When you pass way, the funds that remain in your trust fund will get donated to the charity that you have chosen.
In addition, you will be entitled to an income tax deduction for your charitable contribution. If your estate’s value exceeds the annual estate tax exemption, creating a charitable remainder trust will also separate the value of these assets from the value of your estate, reducing your future estate tax liabilities.
To leave an inheritance behind for your loved ones, you will need to set up a wealth replacement trust when you set up your charitable remainder trust. Your wealth replacement trust will then be funded by the life insurance policy that you purchase.
To make up for the large contribution that you have donated to your charity, you should purchase a life insurance policy with a death benefit equal to your initial charitable donation to the charitable remainder trust. In the example above we used $1,500,000, therefore a policy should be bought with a death benefit of $1,500,000.
Each year, you can pay for the annual cost of your life insurance policy with the money you are collecting from the higher interest rate on your charitable remainder trust, or money that would have been lost to the IRS on the capital gains from your initial investment.
In addition, the contributions you are making into the wealth replacement trust to fund your life insurance policy are untaxed as long as they are less than the annual gift exclusion tax of $17,000 per beneficiary, per contributor. If you and your spouse are taking advantage of this for two children, the annual gift tax exclusion climbs to $68,000.
Remember, anytime you purchase life insurance to leave an inheritance, you will need to purchase a life insurance policy that you will not outlive. The best life insurance policies to leave an inheritance with are guaranteed universal life insurance policies.
These policies provide guaranteed rates and life insurance coverage until the age that you chose and they do not require an investment value; you pay for your life insurance protection only. In addition, your rates are guaranteed not to change regardless of changes to your health, age, interest rates, or the stock market. These policies offer affordable life insurance until the age of 90, 95, 100, 105, 110, 120, or even 121.
We Can Help With All of Your Life Insurance Needs
No matter what type of trust you are considering for your insurance needs, we can help. We work with more than 50 top-rated companies and our agents offer at least a decade of life insurance experience. We have helped thousands of clients just like you.
Most importantly, our agents do not have quotas or shareholders to answer to, only our clients. Give us a call today, or request a free quote online, one of our agents will follow up with you shortly to present all of your options. Toll Free: 855-247-9555
Managing Partner and Co-founder
Cliff is a licensed life insurance agent and one of the owners of JRC Insurance Group. He has helped thousands of families of businesses with their life insurance needs since 2012 and specializes with applicants who are less than perfect health. In his spare time he enjoys spending time with family, traveling, and the great outdoors.
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